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Monetary unions among developing countries: Weighing the costs and benefits of monetary unions

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
December 1981
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Saleh M. Nsouli

In recent years, developing countries have shown increased interest in the that might accrue from monetary integration. The desirability of economic and monetary integration has been; discussed by African, Arab, and Latin American nations and has been an issue raised at various regional meetings; including the Economic Summit Conference of the Organization of African Unity in Lagos, Nigeria, in April 1980 and a conference held at the Arab Monetary Fund in November 1980. In Africa, the Economic Community of West African States considers monetary integration as one of its main objectives in achieving full economic integration among its members and, in the Middle East, one of the principal objectives of the Arab Monetary Fund is the promotion of monetary cooperation among its members.

Despire this increased interest however only two monetary unions are at present functioning in developing countries, both of which are in Africa the West African Monetary Union and the Central African Monetary Union. The relevance of their experience for other developing countries has, however to be qualified by the fact that France has a certain participatory role in both unions. Although the Eastern Caribbean Currency Authority issues a common currency for its seven members, the Authority does not constitute a monetary union since it lacks the power to set monetary policy. The experience of developing countries with monetary integration is, accordingly, very limited Further, while the economic literature has dealt extensively with the issue of monetary integration among industrial countries, very little work has been done at either the conceptual or empirical level on the impact of monetary integration in developing countries.

This article analyzes the factors relevant to the desirability of monetary integration among developing countries. Monetary integration here refers to the process whereby a group of countries forms a monetary union characterized by two main elements: (1) the issuance of a single common currency, the flow of which is unrestricted among member countries, and (2) the establishment of one central monetary authority, which would pool the foreign exchange reserves of all the member countries and decide on the union’s monetary policy. In view of the relative emphasis placed on economic growth in developing countries, the important question is whether monetary integration can promote this objective and, if so, at what cost. Monetary integration could promote growth if it resulted, among other things, in expanded aggregate investment, improved resource allocation, increased domestic savings, enhanced financial intermediation, greater intraregional trade, greater stability for the common currency, and possible savings in international reserves. The costs of integration would stem mainly from constraints it may impose on the pursuit of national fiscal and monetary policies and from the requirement of having a common exchange regime.

Benefits

The establishment of a common currency among a group of countries may have a positive impact on the overall level of investment within the region and improve the pattern of resource allocation. First, the elimination of exchange rate risks within the region and the free intraregional flow of capital would lead investors to consider the expanded regional investment possibilities. It is essential, however, that exchange restrictions between each country in the region and the rest of the world be uniform, otherwise there would be a conduit effect through the country with the least exchange restrictions. Second, domestic financiers may be encouraged to repatriate financial capital and use it for regional investment, thereby supplementing the domestic resources that are particularly important for developing countries with a foreign exchange constraint. Third, as compared with a single-country currency, a common one, in which no single country could take unilateral steps to affect its value, could enjoy greater stability and confidence, inducing foreign investors to invest in the region. Fourth, overall regional resource allocation could be improved by a union to the extent that investors seek the most productive projects within the region. In the absence of a monetary union, investors confined to one country because of exchange risks and restrictions may, in fact, be limited to local investment opportunities and could be investing in projects with increasingly lower returns.

Savings, financial intermediation

Since the low level of domestic savings and inadequate forms of financial intermediation hamper growth in developing countries, the question arises whether a monetary union could promote savings and intermediation. At first blush, the mere existence of a monetary union would appear unlikely to promote domestic savings. However, if a monetary union promotes economic growth because of increased investment and an improvement in resource allocation, per capita income is likely to rise, leading to higher savings. This, of course, would depend on the marginal propensity to save. If the marginal propensity to save were higher than the average propensity to save, then one could expect a rise over time in the average savings ratio. In addition, if confidence in the value of a common currency were higher than that in the original individual currencies, there would be an added incentive for holding savings in a financial form—even assuming an unchanged interest rate.

The tendency for increased savings would be complemented by added incentives for financial activity. Commercial banks would have more opportunities for financial intermediation between countries in the region; investors with excess capital in one country would seek to transfer this capital to other countries in the region with a shortage. To avoid transfers through countries outside the region, local banks would have to provide more competitive services in order to encourage regional investors to use their facilities. Further, the banks themselves, when faced with an excess supply of funds in one country, would seek to channel these funds within the region to a country with an excess demand for funds. Thus, the elements of an interbank regional market would develop. Also, insofar as residents of the union view the common currency with greater confidence and hold their savings in financial form, the return on such savings deposited in the commercial banks would provide a further incentive for residents to deposit their financial holdings with financial intermediaries, thus contributing to the funds available for capital formation.

Promoting intraregional trade

One of the advantages attributed to a monetary union in developing countries is the promotion of intraregional trade, resulting from the elimination of the risk of exchange rate variations among member countries. There are two questions pertaining to this issue: (1) whether a monetary union will actually result in increased intraregional trade and (2) whether such an increase is beneficial for developing countries. To isolate the effects of a monetary union, this article assumes that a customs union is not in effect; in other words, each country maintains its own trade restrictions vis-à-vis the member countries.

Regarding the first question, it is useful to consider three time horizons: the short, medium, and long term. In the short term, it would appear unlikely that a monetary union will, in and of itself, promote intraregional trade. The highly specialized pattern of production in most developing countries is such that they tend to produce similar commodities that are in demand not between each other but in the rest of the world. Accordingly, their production pattern can be characterized as competitive. Even if some small industries produce consumption goods that are in demand in other member countries, factors of considerably greater importance than the exchange risk may impede trade. These include poor transportation networks, inadequate communications, and the availability of similar goods from industrial countries at lower prices.

Over the medium term, some of the infrastructural limitations on intraregional trade can probably be overcome as transportation and communication facilities within the union improve. No significant intraregional trade flows will take place, however, unless the production structure between the member countries becomes complementary. It is possible, given the rise of intraregional investment and the absence of regional exchange risk, that new production projects will take into account the demand for goods within the union. Needless to say, such a development would be considerably encouraged by the formation of a customs union. Thus, while it is unlikely in the short and medium term that intraregional trade will be promoted through the formation of a monetary union, in the long run a more significant expansion in intraregional trade could result from the changing production pattern that will evolve from investment flows in the region.

Whether an increase in intraregional trade is beneficial for developing countries or not will depend on a number of factors. Obviously, the promotion of intraregional trade is not an end in itself but rather a means to other ends—primarily the acceleration of economic growth and the strengthening of the external financial position of the member countries. It is possible that in specific instances member countries may obtain greater returns on investment if projects directed at producing for other countries were developed. For instance, on the basis of comparative advantage, a group of countries could benefit from developing further their traditional export industries—such as agriculture—and using those proceeds to meet their needs for imported manufactured goods. On the other hand, the monetary union could provide an area free of exchange risks that would induce investors to develop large-scale manufacturing industries to meet the import requirements of the member countries. For each particular group, the question of promoting intraregional trade relative to expanding trade with the rest of the world will have to be carefully examined. If gains can be achieved from the promotion of intraregional trade, no illusions should be maintained that a monetary union alone can help; a customs union would also be needed.

Exchange rate and reserves

With a group of countries sharing a common currency, the exchange rate of that currency should be more stable than if each had its own currency, since internal and external shocks would tend to be spread across the countries. For example, if a drought were to occur in one country, the effect of this would be mitigated by the larger productive and export base in the region. Even, however, if the drought were to be regional, its intensity may vary across the countries. Similarly, if members produce different primary commodities for export, the impact of fluctuations in the price of any single commodity will tend to be limited within the overall scope of the union. Given the generally small size of the economies of developing countries and their dependence on a few major export products, the importance of a monetary union to distribute the impact of shocks is of much greater significance than for industrial countries. Industrial countries generally have large and diversified economies that are in themselves capable of diffusing the impact of such shocks.

Another benefit attributed to the creation of a monetary union is the resulting savings on international reserves. Such savings are particularly important to developing countries, which generally suffer from a shortage of foreign exchange. These savings could derive, first, from an elimination of the need to hold reserves for intraregional transactions. Some regions have attempted to duplicate these savings by creating clearinghouses where only net bilateral payments between participants are settled. This, however, results in less savings than a monetary union insofar as countries in a clearinghouse still have to retain reserves to pay for net balances. Second, to the extent that some of the countries in the union have surpluses and others deficits vis-à-vis the rest of the world, the combination of these will result in a lower total imbalance requiring, therefore, a lower total level of reserves. Third, the aggregate balance of payments of the region would be less affected by external and internal shocks than would be the case if each country had to hold reserves separately to meet unforeseen contingencies. The case for reserve savings, however, has to be somewhat qualified. If the region as a whole should somehow peg the exchange rate of its common currency at an inappropriate level, there might be an increased need for reserves.

Costs: monetary constraints

While the potential benefits from a monetary union generally take considerable time to be realized, the costs are more immediate. Perhaps one of the most important concerns is the constraint a union may place on an individual country’s monetary and fiscal policies. As a monetary union requires the establishment of a central monetary authority for the region, decisions relating to monetary policies would have to be made at the union level and the flexibility of seeking central bank financing for budgetary deficits would be limited through collective decision making. Among a group of developing countries, where each is at a different stage of development with different degrees of financial and structural disequilibria, the constraints imposed by a union on the pursuit of individual country-oriented financial policies might be viewed as a hindrance to the achievement of a balanced and sustainable level of economic growth.

In a rather narrow sense, monetary policy can be viewed as the set of actions a country takes to influence the rate of growth of domestic liquidity. Ideally, each country would want to have a rate of growth of domestic liquidity that balances the credit needs of the economy against the inflationary pressures that emerge from excessive monetary expansion. In developing countries, an inadequate expansion of credit to the private sector could slow down the rate of growth of the economy. When developing countries join in a union, it is of paramount importance that the union’s central bank set different rates of credit growth for different countries to meet the requirements of their different growth rates. A well-functioning interbank market could help by channeling funds into regions where there is a stronger demand for credit. This, however, should not be permitted to result in significantly more expansionary monetary policies in some countries within the union, as the emergence of excess demand pressures among the members will tend to spill over from one member country to another.

It is usually agreed that interest rates within a union will have to be maintained at a uniform rate in order to avoid distortions from capital flows within the union. This can have adverse consequences for a group of developing countries, where the returns on projects vary significantly between the member countries. An appropriate interest rate level in one country may be inappropriate for another. For purposes of illustration, consider two member countries with different infrastructures. The return in one country would be considerably higher than in the other. If the interest rate for the union were set at a higher level than the return in the “low-return” country and at a lower rate than the return in the “high- return” country, investment in the “low- return” country could be totally wiped out. Accordingly, there would be a need, in order to avoid imbalanced growth, to study carefully the situation in member countries and to adopt differential interest rates on loans for projects in the “low-return” countries. While advocates of the free market system may feel that such an approach would be against the principles of optimal allocation of resources, this has to be viewed in a dynamic sense, since “low- return” countries would need a period of transition until they reach a stage where the rate of return of investment is commensurate with other member countries.

Fiscal policy constraints

The flexibility of fiscal policy in a union is constrained by the limits collectively set on central bank financing of budgetary deficits. This constraint is less serious for industrial countries than for developing countries. Industrial countries can pursue a relatively flexible fiscal policy by manipulating tax rates and borrowing on the domestic nonbank and bank markets; developing countries, however, face severe limits on the use of tax policy as an instrument—in most cases, income taxes are hard to collect and tariffs are already at a relatively high level. There are also very limited possibilities of borrowing from the nonbank domestic market, while the “crowding out” effect could be severe if large deficits were to be financed from the commercial banking system. Thus, member countries attempting to pursue flexible fiscal policies within the context of the union could be forced to resort to foreign borrowing, increasing considerably the foreign indebtedness of the country.

Even though the constraint imposed on the pursuit of financial policies is touted as a disadvantage, the “discipline” imposed on member countries by a monetary union can be beneficial. The limits set by the collective decision-making process on the ability of any one member to follow excessively expansionary policies could have positive effects on both external and internal financial stability. This, of course, is an oversimplification of the case for a monetary union and overlooks the fact that different countries at different levels of economic development may indeed have to pursue different financial policies. An overemphasis on the desirability of “discipline” could be counterproductive.

Another important implication of a monetary union is a common exchange rate. If the member countries are at different levels of economic development, then it is likely that the exchange rate that would “equilibriate” the balance of payments for the region will not equilibriate the external position of each member country. This may result in undesirable distortions, as the overall common exchange rate may tend to favor some member countries.

This brings us to the implications of a monetary union for regional development, some of which have already been discussed. There are two problems that may arise. First, the least developed countries in the group might be forced to follow excessively austere financial policies that may adversely affect their investment and economic growth. Second, the more developed countries in the region, enjoying a more advanced infrastructure and the presence of industries that would provide external economies to new industries, can become “poles of growth” within the region attracting capital and investment. The least developed countries in the region could suffer accordingly. Obviously such tendencies could to some extent be counteracted by the use of fiscal incentives to attract capital to the other countries, or, as noted above, by imposing different interest rates for loans on projects in different member countries. Such incentives could be gradually removed as the countries achieve a more balanced regional economic infrastructure.

Weighing the factors

To determine whether there are net benefits or costs associated with entering a monetary union, a country would have to weigh the advantages against the disadvantages. The decision, however, is not a purely economic one, as the weights that would be necessary would have to be established by political considerations. In reaching a decision, account would need to be taken of the possibility that, in the short run, some countries entering a monetary union could find themselves incurring net costs, but that, as the union develops, the original parameters might gradually change with the result that net benefits could eventually emerge.

In this connection, if a decision is made to form such a union, detailed preparations must be undertaken to ensure that the process leading to a union is a smooth one. In particular, countries planning to join in a monetary union would have to come close to establishing satisfactory degrees of internal and external financial balance before its inception, in order to avoid undesirable shocks to the member countries and to limit the losses that might initially be involved, such as from disruptive capital flows. In addition, with a satisfactory degree of external balance, the economic and political concerns that surplus member countries could have about financing deficit member countries—concerns that could act as a deterrent to the formation of a union—would be reduced.

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